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Seed Weekly - Aspen – Living Annuities: Caveat Emptor

This report follows on from Ian’s report on Investment Risks (15 April 2014) and considers, in more depth, inflationary risks.

Living annuities have become a commonly used vehicle to provide a compulsory annuity (pension income) to people retiring from retirement products (retirement annuities, pension and provident funds, etc). They have the advantages of flexible investment choice, flexible income choice, the transfer of full income to spouse, and the transfer of the fund value to your dependents on the death of you and your spouse (capital retention). Probably the most common reason given for the use of living annuities is the fact that, whilst they do not “guarantee” a specific income, the use of living annuities is the most effective way of safe guarding a retiree’s income against inflation.

I have done a very basic exercise looking at the effects of different drawdown percentages on the capital and income on living annuities. For the purposes of this calculation I have assumed an inflation rate of 7% pa, a return (after costs) of 11% pa, and a constant drawdown percentage.

The first chart looks at the monthly drawdown (based to 100) from a naïve point of view – i.e. not taking inflation into account. From this chart it appears that an investor’s income would be nearly 6 times greater after 30 years of retirement in the case of a 5% drawdown, and that an investor can even withdraw 10% on an annual basis and still have income growth in retirement – both rosy pictures for the naïve investor. Unfortunately this isn’t the case in reality.

A more accurate, and necessary, approach is to consider the effects of inflation when looking at how various levels of withdrawal affect the sustainability of an income into retirement. The following chart repeats the above, but takes into account the effects of inflation – the correct approach to financial planning – and as can be seen the picture isn’t as pretty. Whilst a number of financial advisors would say that their portfolios have achieved returns way in excess of 11% pa, it is my opinion that budgeting for returns far in excess of 4% above inflation (after all costs) are not sustainable over the long term for retirees.

It is a very sobering picture that even using a drawdown percentage of 5% (I’ve been told by linked product companies that the average draw down percentage is much higher than this), both your capital balance and your income do not keep up with inflation. When we move up to a drawdown percentage of 7.5%, both your capital and income have more than halved in real terms over 30 years.

What many pensioners do, in order to maintain their living standards, is increase their drawdown percentage during retirement. Increasing your drawdown percentage from a marginal/breakeven position unfortunately has disastrous effects on the capital value of the portfolio and seriously puts into jeopardy the sustainability of any income for a reasonable retirement period.

So, whilst living annuities are still the best product available in many circumstances for the provision of retirement income, they need to be sold with the words caveat emptor “let the buyer beware”. Both income levels chosen and real returns achieved will drastically affect the living annuity’s ability to protect the retiree from the ravages of inflation.

Investors should endeavour to have their starting drawdown (as a percentage of total assets) as low as possible to ensure that the returns from the living annuity are able to cover (in real terms) the majority of the drawdown. In this way investors will maximise the probability of not being left high and dry.

Seed Weekly - Value Investing the Buffett Way (Part 6 2003 – 2007)

2003 marked the first positive year on the S&P500 following the Dotcom bubble. The US stock market experienced another bull market period leading up to the start of the financial crisis in 2007.

By this time Warren Buffett has been around for so long that he has a very good feeling for the market and also for big US companies. During 2003 he mentions of his purchase of McLane, a subsidiary of Wal-Mart: “We did no “due diligence.” We knew everything would be exactly as Wal-Mart said it would be – and it was.” For Buffett – it’s much more than just a company he purchases – it’s a belief in their management, integrity and product.

He wants to be able to make a character judgement on the company and its management and preferably management must own a stake in the business. “Charlie and I love such honest-to-God ownership. After all, whoever washes a rental car?” He praises the owner of one of Berkshire’s star companies, the Belarus-born “Mrs B” who died during 2003 at the age of 103 and had worked until her death. Her company motto was “sell cheap and tell the truth”. Being a low cost producer demands success, but if a business requires a superstar manager to produce great results, the business itself cannot be deemed great. “The company should be simple that it can be run by a monkey”. Unfortunately, finding these businesses is not that common and Mr Buffett admits “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”

Interestingly, during 2003 Berkshire Hathaway sent the US Treasury $3.3 billion for tax on its 2003 income, a sum equalling 2½% of the total income tax paid by all US corporations. In contrast, Berkshire’s market valuation at that time was about 1% of the value of all US corporations. “Our payment will almost certainly place us among our country’s top ten taxpayers.”

Berkshire ended 2004 with $43 billion of cash equivalents, not a happy position. “Charlie and I will work to translate some of this hoard into more interesting assets during 2005, though we can’t promise success”

As always, Mr Buffett makes investing into stocks seem so simple. In his 2006 letter he tells the story of one of his long-time friends, Walter Schloss, who managed a remarkably successful investment partnership. He didn’t take a dime unless his investors made money. Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts. “We try to buy stocks cheap.” He built this record by investing in about 1,000 securities, mostly of a lacklustre type.

“So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms. Walter produced results over his 47 years that dramatically surpassed the S&P 500. And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching Efficient Market Hypothesis made any attempt to study Walter’s performance and what it meant for the school’s cherished theory. Walter meanwhile went on over performing, his job made easier by the misguided instructions that had been given to those young minds.” Buffett frequently made known his thoughts on investment academics and participants.

By the time that his 2007 letter was published the credit crisis had started. Just about all Americans came to believe that house prices would forever rise. That conviction made a borrower’s income and cash equity seem unimportant to lenders, who shovelled out money, confident that house price appreciation would cure all problems. Some major financial institutions experienced staggering problems because they engaged in “weakened lending practices”. “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.” The next article will cover this crisis in more detail.

Seed Weekly - Considering all Investment Risks

While virtually all investors acknowledge that investing involves taking on risk, most investors do not know or take the time to clarify these risks and also to understand the interplay. For example, an investor may be overly concerned about taking on too much market risk and when reducing this risk too much, inadvertently takes on too much longer term inflation risk with a more conservatively constructed portfolio.

It ultimately all comes down to how you define risk and on which aspect an investor places the highest value. A good definition of risk is: “The chance that an investment's actual return will be different than expected because risk includes the possibility of losing some or all of the original investment.”

A typical investment risk pyramid may look something like this, but this is too simplistic a view of the actual risks that an investor faces.

Firstly, for most investors is the mortality or actuarial risk. This is the risk that having saved up a quantum of savings over your productive life, into your retirement years you run out of savings as you live longer than expected, drawing down too quickly on your accumulated savings.

Then there is inflationary risk. Where an investor aims to achieve a rate of return of at least the inflation rate over time from his investment portfolio, there is a risk that his investments will not achieve this return because of inferior performance or where inflation becomes rampant and at worst hyperinflation.

Ironically in times of very high inflation and hyperinflation it is the relatively "safe" investments such as fixed income investments that are the highest risk investments, while the typically understood “risker” investments such as shares, are the lowest risk, in that they have a higher probability of preserving purchasing power.

Once an investor has considered these two main risks, he needs to consider the following, which individually and collectively impact on the mortality and inflationary risk:

• Market risk is the risk that the value of your investments fluctuates and at worst, in a major market decline, results in permanent loss of the original capital invested. This is the one risk that many investors fear more than any others, often without having properly considered mortality and inflationary risk.
• The risk of default is one where an investor expects a certain guaranteed return typically from a fixed interest investment such as a bond issued by a government or a corporate and before maturity of the fixed investment, the issuer defaults, with the investor not being fully paid out and in the worst case scenario receiving nothing back.
• Liquidity risk is the risk that when the investor wants to convert the investment into readily available cash he is unable to do so for various reasons. Typically speaking less liquid investments, for example private equity, should generate higher returns that a money market investment. Part of the reason for generating this higher return is the higher liquidity risk.
• Interest rate risk is risk generally associated with an investment into fixed interest investments. While these investments are typically understood to be in the lower risk category, where an investor has, for example, invested into a 10 year bond yielding 8.5% pa, the risk to the investor is where interest rates move up and now similar bonds yield 10.5%. In such a case the investor will suffer capital loss.
• Another risk each investor faces is political risk. This is because governments have far reaching ability to implement legislation that can severely impact companies, taxes, and property ownership rights for example. While certain governments around the world are seen to be “investor friendly” there are many that have a far more inconsistent approach to legislation, increasing this risk.
• Currency risk arises due to a global economy where one currency floats against another. Being exposed to just one currency is itself a risk, but where an investor converts a portion of his investment into another currency, he runs a currency risk should that currency in which he invested decline on a relative basis. South Africans have typically benefitted from currency risk, but there have been long periods of time where the Rand has appreciated and then this risk is more fully appreciated.

When looking at risk in this context, it is less important and indeed less meaningful to try and ascribe a single number to risk, such as standard deviation or price volatility. It is far more meaningful to consider each risk and its potential impact on the investors financial planning and the total portfolio.

Seed Weekly - Fund Manager Warning Signs

In last week’s newsletter, Multi Management Unveiled, we discussed the benefits and drawbacks of multi managers in helping investors achieve their investment objectives. The article also alluded to other benefits of being invested into multi managed funds.

Finding the correct underlying managers and developing the optimal strategy for a multi managed fund is only the initial responsibility of a multi manager. After an underlying fund has been included into a multi managed fund, the multi manager needs to monitor, inter alia, the following aspects:

“Past performance is no indication of future returns” is well know and used phrase in the investment world. A portfolio manager might have outperformed his/her investment objective in the past, but will this continue going forward? A multi manager needs to monitor the performance of the fund and check if the performance deviates from expectations.

A multi manager shouldn’t only be concerned if the fund underperforms, but also if it outperforms when it shouldn’t. An example is when a conservative manager outperforms in a bull market – the manager may be taking on unnecessary risks.

Change in Portfolio Manager

The portfolio manager and investment team tend to be the most important part of a fund’s performance. When a portfolio manager leaves, the multi manager needs to have an opinion on the manager that’s taking over and the depth and expertise of the remaining investment team.

The graph below shows the drop in AUM of a fund after a change in portfolio manager was announced at the end of 2013. The investors (including multi managed funds) clearly didn’t feel comfortable with the new arrangements and disinvested.

The graph below shows a fund that had two manager changes, one in September 2009 and the other in October 2012. On both occasions the investors were content with the new managers coming on board and didn’t see the need to disinvest.

At Seed, when there is an unannounced portfolio manager change, the fund is automatically removed from all short lists and only after we are able to meet with the new portfolio manager we will either put the fund back on the short list or disinvest.

Change in Assets Under Management (AUM)

An asset manager earns most of their income from the investments that they manage. When there is a sudden drop in AUM, it will lead to lower income earned and possibly become a going concern risk. Even if the asset manager is able to stay afloat, their priorities will in all likelihood change to focus more on generating new business (i.e. spend less time managing existing funds).

Boutiques and medium sized managers that have a few pension/institutional clients dominating their AUM are most at risk. There is a local asset manager that lost close to 90% of their AUM when institutional clients pulled their investments.

Style Drift

One of a multi manager’s goals is to blend uncorrelated investment styles in order to reduce the volatility of the fund and increase returns over the long term. When a manager’s style drifts, the underlying funds can become correlated and the benefit of diversification reduced.

The graph below shows how a manager’s investment style can change over time. The fund started off investing into Small cap value companies and over the years moved over to Mid/Large cap growth companies.

The benefit of a multi managed fund is peace of mind for investors. Multi managers continuously monitor the investments in the fund (across a variety of metrics) and keep an eye out for new and improved strategies/managers to incorporate.

Seed weekly - Multi Management Unveiled

I was recently asked to explain what a multi manager is and how they differ and/or compare to single managers. Afterwards, while thinking about my explanation, I decided to do a little research on the topic.

The below table compares single manager against multi managers and also serves as a broad definition:

As can be seen above, a multi manager provides an investment solution by utilising or combining the skill of more than one investment (single) manager. The idea of multi management is based on the premise that single managers are unlikely to perform well in all market conditions and in all circumstances.

To illustrate, I selected four uncorrelated single managed equity funds and then blended them together (similar to a multi manager). The results of the Risk/Return scatter plot are below:

The result shows that although all the Funds comfortably outperformed the ALSI, the Equity Blend does not quite perform as well as Funds C and D, but comfortably outperformed Funds A and B with a lower standard deviation than Funds B, C and D.

The key here is that a multi manager needs to ensure that the chosen managers are sufficiently different and uncorrelated. They need to look for a blend of managers who are able to outperform over the long term, but have complimentary styles to reduce volatility or minimise risk over shorter time periods. This ensures that proper diversification is possible and that they do not generate similar patterns of relative performance. Your end result will be a portfolio that benefits throughout the investment cycle with consistent returns and lower drawdowns (protecting capital).

The biggest argument against multi management, of course, is costs. Each underlying manager charges a fee which is added on to the multi manager’s fee. One therefore needs to control costs to avoid limiting outperformance. The extra costs are mitigated, to a certain extent, by the ability of a multi manager to negotiate down the fees with the underlying managers as they are able to invest larger amounts than retail investors.

At Seed Investments we pride ourselves as multi managers that are able to largely overcome the cost problem by structuring our portfolios on a core and satellite basis. The core is generally provided through smart beta products (see “Smart Beta” here http://www.seedinvestments.co.za/news) - hence significantly lowering cost. On the satellite side we utilise segregated mandates with a carefully selected group of active managers. These have been designed exclusively for us, to fit our Funds’ specific needs, and aren’t available to retail investors.

From the above findings it is evident that a multi manager, able to combine superior performing, uncorrelated fund managers, at a competitive cost, will have a place in most investors’ portfolios as it enables investors to achieve their investment objects more efficiently and at a lower risk. There are other advantages to multi management, such as tracking manager movements and keeping an eye on Manco AUM, which will be addressed in a future newsletter.